Financial hedging is an advanced strategy that helps to manage and offset risks within your trading and investment portfolio. Learn about some of the most effective hedging strategies that can be used when holding assets or trading CFDs within the financial markets.
You might’ve hedged and not even known about it as people hedge in everyday life as well as on financial markets. For example, people view insurance as hedging against future scenarios – as hedging will not prevent an incident from occurring, but it can protect you if the worst should happen.
How to Start Hedging – Quick Guide
There are two ways to start hedging, depending on your level of confidence and expertise. Your options are:
- Open an account. You can open an account with CAPEX.com quickly and easily
- Practice trading on a demo account. Test your hedging strategies in a risk-free environment with a CAPEX demo account
Alternatively, you can join CAPEX Academy to learn more about financial markets.
What is Hedging
Hedging is the practice of opening multiple positions at the same time to protect your trading or investment portfolio from volatility or uncertainty within the financial markets. This involves offsetting losses on one position with gains from the other.
This means that if one instrument declines in value, the other is likely to increase, which can help to offset any risk from the declining position with a profit. These investment decisions should not be rushed and require a lot of thought and analysis beforehand.
Typically, hedging is a risk management strategy used by short to mid-term traders and investors to protect against unfavourable market movements. Many long-term investors never use hedging as they tend to ignore short-term fluctuations altogether, but it is still important to learn about the process because it can have a range of different applications.
Why Do Traders and Investors Hedge?
- To avoid volatility risk on forex positions (Forex Hedging)
- To avoid liquidating shareholdings (Portfolio hedging)
- To avoid currency risk on foreign assets (Currency Hedging)
*It’s important to understand that when traders hedge, they do so not as a means of generating profit but as a way of minimizing loss. All trading involves risk because there is no way to prevent the market from moving against your position, but a successful hedging strategy can minimize the amount you would lose.
1. Avoiding volatility risk on forex positions (Forex Hedging)
For some, the allure of trading forex is that it’s incredibly volatile and fast-paced, but for others, there is a desire to reduce excessive risk where possible. While many traders will manage their risk by attaching stop-losses, there are some that choose to use forex hedging strategies. These include:
Simple forex hedging strategy
Opening the opposing position to an existing trade is a simple and straightforward forex hedging method. For instance, you could decide to open a short position on the same currency pair if you already held a long position in that pair. This is referred to as a direct hedge.
Although a direct hedge has no net profit, you would preserve your initial position in the market to be ready for when the trend changes. If you elected to hedge the position, it would allow you to make money with a second trade when the market swings against your first. If you didn't decide to hedge the position, closing your trade would mean taking any loss.
Some forex brokers do not offer the opportunity for direct hedges and would simply net off the two positions.
Multiple currencies hedging strategy
Choosing two positively correlated currency pairs, such as GBP/USD and EUR/USD, and then placing positions on both pairs but in the opposite direction is a frequent FX hedging strategy.
Think about hedging your USD exposure, for instance, by placing a long trade on GBP/USD after taking a short one on EUR/USD. Your long position on GBP/USD would have suffered a loss if the pound did decline against the dollar, but it would be partially offset by the profit on your EUR/USD position. Your hedge would cover any losses to your short position if the US dollar declined.
It's necessary to keep in mind that hedging multiple currency pairs entails certain risks. While you would have hedged your exposure to the dollar in the case above, you would also have exposed yourself to a short exposure on the pound and a long exposure on the euro.
If your hedging plan is successful, you may even turn a profit while reducing your risk. If you used a direct hedge, your net balance would be zero, but if you used a multiple currency strategy, it's possible that one position could bring in more money than the other position does in losses.
But if it doesn’t work, you might face the possibility of losses from multiple positions.
Hedging forex with options
FX options are a form of derivatives products that give the trader the right, but not the obligation, to buy or sell a currency pair at a specified price with an expiration date at some point in the future. Forex options are mainly used as a short-term hedging strategy as they can expire at any time. The price of options comes from market prices of currency pairs, more specifically the base currency.
Let’s say that a trader decides to make a ‘put option’ and short-sell USD/TRY or buys an amount of Turkish Lira against the US Dollar but thinks that there may be a rise in price. He can then make a ‘call option’ and buy an equal amount of USD/TRY at the same time to profit from the potential rise in price. This way, the trader is hedging any currency risk from the declining position, and this is more likely to protect him from losses.
Start hedging forex
- You can test out your hedging strategies in a risk-free environment by opening a demo trading account with CAPEX.com. If you are ready to implement your forex hedging strategy on live markets, you can open an account with CAPEX.com – it takes less than five minutes, so you can be ready to trade on live markets as quickly as possible.
- Our online trading platform, CAPEX WebTrader, makes currency hedging a simple process. Additionally, our deep integration with TradingView offers advanced chart features to compare symbols and spot hedging opportunities.
- You can also take advantage of our mobile trading apps, including software for both iOS and Android. It is easy to trade while you are on the go, without the comfort of your home desktop.
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2. Avoiding liquidating shareholdings (Portfolio hedging)
Stocks do best during bull markets. A portfolio of equities is exposed to weakness in economic growth – when growth falls, employment declines, and consumer and business spending drops. Equities are a means to benefit from rising corporate earnings, which are driven by consumers and businesses spending money. If earnings growth is expected to be negative, then investors tend to sell shares, driving down prices and causing bear markets (ie prolonged falls in share prices). A portfolio of shares will thus fall in value during periods of economic weakness.
Hedging by going short on stocks
Investors should look for the best performers during bull markets. Traders should seek to short the worst performers in bear markets, where stocks decline over time. Traders might lessen the losses on the 'long' portion of their portfolio by shorting stocks. Derivatives such as CFDs, which give users access to a variety of global equities, can be used to do this.
Investors and traders who use leveraged trading through CFDs can profit from declining prices without worrying about the requirement for currency conversions. Although the gains from these short positions might not completely compensate for the losses on the main portfolio, they can nonetheless serve to lessen these losses.
Hedging with ETFs
Investors can hedge their portfolios without using derivatives or other sophisticated financial products thanks to exchange-traded funds (ETFs). ETFs are more appealing to some investors due to their low cost and simplicity of use. A portfolio of long stocks can be hedged using an ETF that seems to be short a headline index, such as the USA 500, as the ETF makes money when the underlying index declines. Again, utilizing such ETFs should be seen as a short-term investment, like taking short positions on stocks.
Hedging with indices
Just as traders using CFDs can use short positions on individual equities to hedge their main investment portfolio, they can employ short positions on the indices themselves, in a similar fashion to the use of short ETFs. Again, the declines in the index see investors make profits on their short positions, although as before these short positions are more used as a short-term hedge in corrections or bear markets, rather than as long-term positions over many years.
As with shares and ETFs, the hedge is not designed to remove all the risk from a market decline, but to mitigate it. Since it uses leverage, it must be used in conjunction with a proper risk management approach, so that a sudden rally in the market does not result in a significant loss that renders the whole exercise of hedging pointless.
Start hedging your portfolio
- Practise hedging your investment portfolio with $50,000 of virtual funds with a CAPEX demo account. Or if you're ready to start trading, open a live account.
- With CAPEX.com you can trade CFDs on 2,100+ shares, indices and ETFs from a single Trading Account. You can also buy shares in inverse and leveraged ETFs with an Invest Account.
3. Avoiding currency risk on foreign assets (Currency Risk Hedging)
When a change in the value of one currency relative to another causes a rise or decline in the value of an asset, exchange rate changes have an impact on returns. The only thing that may change when an investor purchases a domestic asset is whether its value rises. However, they will also need to take the effect of an exchange rate into account if they invest abroad. This has a straightforward fundamental purpose: as a local currency appreciates, it has a lower purchasing power since it can now buy a smaller amount of a foreign currency. Additionally, a local currency's purchasing power increases when it gains value since it can now buy more of a foreign currency.
When managing currency risk, it's crucial to keep in mind that when you establish new fx positions to offset your exposure to foreign exchange, you're also accepting the risk of those new holdings. The requirements for hedging FX positions themselves will vary.
Hedging currency risk with specialized ETFs
While less conventional, one way to hedge foreign exchange risk is by investing in a specialized currency exchange-traded fund (ETF). In principle, a currency ETF functions just like any other ETF, but rather than holding stocks or bonds, it holds currency cash deposits or derivative instruments tied to an underlying currency, which mirror its movements. For example, the ProShares UltraShort Euro ETF, Currency Shares Euro Trust, or the Invesco DB US Dollar Index Bullish Fund.
A trader can go long or short on these ETFs, depending on the required hedge, to protect the value of an investment or cash flow from a currency’s (or multiple currencies’) volatility.
Hedging currency risk with CFDs
A contract for difference (CFD) is a derivative that can be used to hedge foreign exchange risk – to open a CFD position, the trader is not required to own the underlying currency. A CFD hedge works because you are agreeing to exchange the difference in the price of a security – in this case, currency – from when the position is opened, to when it is closed. If the market moves in the direction the trader predicted, they would profit and if it moved against them, they would lose.
A CFD position can be used to offset the currency exposure of the asset being hedged. Because CFDs are a leveraged product, only a small amount of capital is required to enter the hedge. Furthermore, the hedge can be closed via cash settlement, limiting the potential financial outlay of the trade.
Hedging currency risk with forward contracts
A forward exchange contract (FEC) is a derivative that enables an individual to lock in an exchange rate in the present for a predetermined date in the future. The benefit of a forward is that it can protect an individual’s assets from exchange rate movements by locking in a precise value now. The cost or benefit of buying a forward is known at its purchase, with the forward exchange rate calculated by discounting the spot rate using interest rate differentials.
Start hedging your currency risks
- Open an account. You will have access to 55 currency pairs and several specialized ETFs.
- Consider how much capital you have available. Placing multiple positions will come with extra costs, especially if holding positions overnight or applying order types. See an overview of our trading costs.
- Don’t assume that hedging is an alternative to risk management. You could still apply stop-losses on positions where you think the market is particularly volatile, for example.
- Learn more about CFD trading. CAPEX Academy contains a wide range of free trading courses for beginners and advanced traders.
Best hedging strategies
There are several methods that can be used to hedge, but some can be extremely complicated. That’s why we’ve looked at some of the most widely used ways of hedging against risk – whether this is a specific strategy, a platform function, or an asset class that is considered a hedge. These hedging strategies are:
1. Direct hedging 2. Pairs trading 3. Trading safe havens
Direct Hedging
A direct hedge is the strategy of opening two directionally opposing positions on the same asset, at the same time. So, if you already have a long position, you would also take a short position on the same asset.
The advantage of using a direct hedge, rather than closing your position and re-entering at a better price, is that your trade remains on the market. Once the negative price movement is over, you can close your direct hedge.
Direct hedging is beneficial for shareholders and long-term investors that do not want to liquidate shareholdings during market downturns. It is also important for individuals and companies to reduce the risk of adverse commodity price movements.
Pairs trading
Pairs trading is perhaps the most commonly utilised method of hedging. The best way to describe pairs trading is essentially as a long-short hedge strategy, meaning that it’s market-neutral. It doesn’t matter if the two securities involved belong within the same asset class, as long as there is a positive correlation between them.
To carry out a pairs trading strategy, the trader should identify when one asset is overvalued and one is undervalued, where their deviating values are calculated using the standard deviation. They can then choose to open a buy position to go long on the asset that is undervalued, and short sell the overvalued position. To make a profit, the assets should reverse back to their original positive correlation.
It can be applied to stocks in the same sector or related sectors (one company can benefit at the expense of another), or indices when one country may outperform. One can often pairs trade similar commodities to take advantage of changes in relative outperformance or volatility, such as crude oil vs natural gas or gold vs silver.
Trading on safe-haven assets
Safe-haven assets are financial instruments that tend to retain their value, or even increase in price, during periods of economic downturn. There is a range of assets that fall into the categories of both safe havens and hedges.
Gold
The precious metal has often been considered a ‘safe haven’ for many investors, due to its rarity, reliability, and stability within the commodities market. The value of gold remains constant after many years, and in times of political, social, and economic uncertainty, traders may choose to invest in gold to hedge their positions in other suffering markets. It is also a hedge against inflation diluting the purchasing power of fiat currencies (particularly those most widely held, like the USD and EUR). The price of gold also tends to increase when the stock market crashes, so stock traders may focus on this commodity in times of increasing downside volatility.
Government bonds
Debt securities such as treasuries (T-bonds) and government bonds (gilts) are generally considered to be safe investments all year round. They provide a fixed rate of return until their expiry date, and when they mature, the government pays the bondholder the face value of the bond. This means that any principal invested is then repaid to you. Although government bonds tend to attract less risk-tolerant investors, they can still be affected by interest rates, inflation, and currency strength for a particular economy, just not as strongly as other financial markets such as the stock market. In times of market uncertainty, government bonds are typically seen as a safe haven.
Currency pairs
Currencies such as the US dollar (USD), Swiss franc (CHF), and Japanese yen (JPY) are generally considered to be safe havens within the FX market. This is because their economies are particularly strong (the US has the largest economy in the world) with stable interest and exchange currency rates. The USD is the world’s global reserve currency, meaning that it’s used for many business deals and often won’t be dented by domestic or international uncertainties. Switzerland also has a low-volatility capital market, stable government, tax-friendly policies for the wealthy, and minimal unemployment, which traders can take advantage of in times of market uncertainty.
How to Hedge
To start hedging, there are a few steps every trader and investor should follow. These are:
Testing some CFD hedging strategies
Let’s explore how to utilize financial hedging in the foreign exchange and stock market as part of a CFD trading strategy for a shareholder that already owns company stock from elsewhere.
Investor responses to potential volatility depend on their individual circumstances and approach. For active investors, the risk-averse, and those with concentrated holdings in a single stock, hedging may be a viable option.
How to hedge a Forex position?
Let's take an example of a political situation, say, trading the US election. We could use a forex correlation hedging strategy for this, which involves choosing two currency pairs that are directly related, such as EUR/USD and GBP/USD.
If you are looking to hedge your USD exposure, you could open a long position for GBP/USD while shorting EUR/USD. This means that if the dollar appreciates in value against the euro, your long position will result in losses, but this would be offset by a profit in the short position. On the other hand, if the dollar were to depreciate against the euro, your hedging strategy would help to offset any risk to the short position.
How to hedge a short stock position?
An investor that owns 1,000 Tesla shares and is concerned about a share price drop after an announcement, such as an earnings report, may establish an account with CAPEX.com. In the lead-up to the company report, the investor opens a position to short-sell 1,000 units. The price at which the CFD trade is executed is “locked in”.
If the value of Tesla stock falls, losses on the shareholding could be offset by gains on the sold CFD position. It’s important to note that this also means that the shareholder will not benefit from any post-result TLSA rally. Any gains on the rise in Tesla shares may be neutralized by losses on the sold CFD position. This type of hedging strategy reduces the market risk of holding a share (to zero when executed properly), but there are other risks and costs that investors must consider.
How to hedge a property being sold overseas?
Let’s say you’re a US-based investor, who is planning to sell a property in Europe in six months. At the current EUR/USD exchange rate of 1.20, your €250,000 villa is worth $300,000 (250,000 x 1.2). You’re concerned that the dollar will strengthen against the euro, which would lessen the value of your foreign investment.
To hedge your foreign exchange exposure, you decide to take out a short EUR/USD CFD – buying the dollar while selling the euro. One EUR/USD contract is worth €100,000 so you would need to take an exposure equivalent to 2.5 contracts to balance the currency exposure of your €250,000 villa. For CAPEX.com clients, one contract is the equivalent of $10 per point, so 2.5 contracts would give you $25/per point. You’d open your position to sell EUR/USD at the current bid (sell) price of 1.20.
Once you’d placed your short CFD trade, if the dollar did strengthen against the euro, the profit to the CFD position would mitigate some of the loss in value of the property. If the price of EUR/USD fell, you might decide to close your trade at the ask (buy) price of 1.05. The market would have moved by 1,500 points in your favor – earning you $37,500 (1,500 x £25) before other trading costs.
At the same time, the price of your property would have been adversely impacted by this decline in the value of EUR/USD. At the new spot price of 1.05, your European villa would be worth $262.500 – a loss of $37,500. This loss would now have been hedged by the profit to your short CFD trade.
Had your prediction been incorrect, and the dollar did not appreciate, the loss to your CFD trade could be partially offset by the advantageous exchange rate on your property sale.
Example of a pairs trading strategy
Let’s say that you decide to open a long position for gold and short an equivalent amount of silver in a pairs trade. Your returns would vary depending on how the two precious metals perform relative to each other, demonstrated in the following examples.
- Both sides move up or down the same amount: If gold and silver move the same amount on a percentage basis, the returns on the two sides of the trade should offset each other. For example, if both went up 10%, the 10% gain on the long gold position would be offset by the 10% loss on the short silver position, leaving you at breakeven. If both fell by 10%, the profit on the short silver position would be offset by the loss on the long gold position. Hence, the two positions hedge each other.
- Both sides move up: If gold moves up 10% and silver climbs 8%, the 10% gain on gold would be partially offset by the 8% loss on silver, leaving you with a 2% gain. If silver moves up 10% and gold only advances by 8%, the gain on gold would be more than offset by the loss on silver, leaving you down by 2%.
- Both sides move down: Consider that both metals fall and gold drops by 8%, while silver falls by 10%. The gain on the short silver position would be partly offset by the loss on the long gold position, leaving you with a 2% net gain. If silver were to fall 8% and gold was to drop 10%, however, the loss on the gold position would more than offset the gain on the silver position, leaving you down by 2%.
- Both sides move your way: Suppose you catch a break and gold advances 10% while silver declines 8%. The 10% gain on the long gold position, coupled with the 8% gain on the short silver position gives you an 18% return on the pairs trade.
- Both sides move against you: One major risk in pairs trading is that you could get squeezed if both sides of the trade go the other way. Suppose gold falls by 8% and silver climbs by 10%, the 8% loss on the gold position coupled with the 10% loss on the silver position would hand you an 18% loss on the pairs trade.
Costs of hedging with CFDs
Naturally, there are costs involved in establishing the CFD position.
Holding costs
Holding a position overnight will result in overnight fees, although if the CFD position is open for just a few days, these are likely minimal.Margin required
Establishing a long or short position in CFDs requires an initial margin. This is usually in the range of 3.33% to 20%, depending on the size and liquidity of the instrument, making CFDs a more capital efficient form of hedge.Tax consideration
These are dependent on individual circumstances but CFDs usually require you to pay capital gains tax, although they are exempt from stamp duty.
Holding costs: holding a position overnight will result in overnight fees, although if the CFD position is open for just a few days, these are likely minimal.
Margin required: establishing a long or short position in CFDs requires an initial margin. This is usually in the range of 3.33% to 20%, depending on the size and liquidity of the instrument, making CFDs a more capital-efficient form of hedge.
Tax consideration: these are dependent on individual circumstances but CFDs usually require you to pay capital gains tax, although they are exempt from stamp duty.
Before carrying out a hedging strategy, you should try to calculate whether the risk-reward ratio is worth it; in other words, whether the amount you pay to open multiple positions will supersede the losses saved on a particular trade.
Advantages and Disadvantages of Hedging
Hedging is a technique used to manage risk, but it’s important to keep in mind that nearly every hedging practice will have its own downsides. First, as indicated above, hedging is imperfect and is not a guarantee of future success, nor does it ensure that any losses will be mitigated. Rather, investors should think of hedging in terms of pros and cons.
What are the advantages of hedging?
What are the disadvantages of hedging?
- Hedging helps to limit losses and lock in profit.
- The strategy can be used to survive difficult market periods.
- It gives you protection against changes such as inflation, interest rates, currency exchange rates and more.
- It can be an effective way to diversify your trading portfolio with numerous asset classes.
- Helps to increase liquidity within the financial markets.
- No trading strategy is completely risk-free; therefore, you should still take appropriate action for managing risk within your trades, such as applying stop-loss orders and other controls.
- As hedging rarely helps a trader to profit, it can only mitigate losses at best.
- Hedging involves cost that can eat up the profit.
- Risk and reward are often proportional to one other; thus reducing risk means reducing profits.
- For most short-term traders, e.g.: for a day trader, hedging is a difficult strategy to follow.
The Bottom Line
As we have seen, hedging is achieved by strategically placing trades so that a gain or loss in one position is offset by changes to the value of the other. This can be achieved through a variety of strategies, such as opening a position that directly offsets your existing position or by choosing to trade assets that tend to move in a different direction from the other assets you are trading.
As there is a cost associated with opening a new position, you would likely only hedge when this is justified by the reduced risk. If the original position were to decline in value, then your hedge would recover some or all those losses. But if your original position remains profitable, you can cover the cost of the hedge and still have a profit to show for your efforts.
An important consideration is how much capital you have available to hedge, as placing additional trades requires additional capital. Creating a budget is vital to ensuring that you do not run out of funds. A common question is ‘How much should I hedge?’, but the answer will vary from trader to trader, depending on their available capital and attitude to risk.
The amount you should hedge depends on whether you want to completely remove your exposure, or only partially hedge a position. Hedging should always be tailored to the individual, their trading objectives, and their desired level of risk.
Free resources
Before you start hedging your trades and investments, you should consider using the educational resources we offer like CAPEX Academy or a demo trading account. CAPEX Academy has lots of free trading courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader or make more-informed investment decisions.
Our demo account is a suitable place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how CFDs work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged trading.